When you first sign up for a 401(k) plan through your employer, you'll generally be bumped into that plan's default investment option until you choose investments of your own. And chances are, that default option will be a target date fund.
A target date fund is a mutual fund that adjusts your investments over time to meet a specific milestone, and they're a popular choice for retirement savings plans as well as 529 plans for college. But is it smart to invest in a target date fund, or should you take a more hands-on approach to managing your money?
The upside of target date funds
The great thing about target date funds is that, like index funds, they take a lot of the guesswork out of investing. In the context of retirement savings, for example, you take your age and your estimated retirement date, and your target date fund does the rest.
That fund will be set up to start you off with more-aggressive investments that allow you to grow wealth, but as retirement nears, it will shift you over to safer investments, like bonds, that are a better choice later in life. That way, if there's a stock market crash within six months of your estimated retirement date, you won't risk losing a massive chunk of your savings to poor timing.
The downside of target date funds
While target date funds make investing for milestones like retirement easy and simple, they have their drawbacks. First of all, target date funds often lean conservative to begin with, which means if you invest in one, you could end up snagging lower returns in your retirement plan than you'd otherwise enjoy by hand-picking different stocks.
Of course, the opposite could end up being true, too. If you're more risk-averse than the typical saver, you may find that target date funds are too aggressive for your comfort level.
In fact, a major limitation of target date funds is that you don't get any control over your investments. And while the same holds true for any mutual fund or index fund you buy, it's something to consider nonetheless.
Target date funds can also charge hefty fees that exceed those of index funds, which are passively managed. Those fees can eat away at your returns and limit the extent to which your savings get to grow.
So what's the right call?
Deciding whether or not to invest in target date funds should really boil down to being honest about how much effort you're willing to put in as an investor. If you don't have the patience for investing or the head for it, then target date funds may be a good solution. But if you're up to the challenge of choosing your own investments, you may be able to assemble a portfolio that costs you less to maintain while delivering higher returns.
Of course, you could also choose to divvy up your long-term investments between ones you select yourself and target date funds. That way, you get the peace of mind that comes with having a chunk of your assets taken care of while you try to figure how to best manage the rest.